#### Transcript ECON 1001

```ECON 1001
Midterm #1 Revision
Q1) After paying the movie distributor and meeting all
other non-interest expenses, the owner expects to net
\$2.00 per ticket sold. Construction costs are
\$1,000,000 per screen. How many screens should be
built if the real interest rate is 7% ?
Number of
Screens
1
2
3
4
5
Total number
of patrons
50,000
90,000
120,000
140,000
150,000
A)
B)
C)
D)
E)
1
2
3
4
5
Ans: B
•We should use a ‘cost-benefit’ analysis
•In particular, ‘Marginal Benefit vs Marginal Cost’ of
installing ONE MORE screen.
•MB of installing ONE MORE screen
=(increase in patrons)∙\$2
Installing the
1st
↑ in patrons
50000
↑ in revenue (MB)
\$100000
2nd
3rd
4th
40000
30000
20000
\$80000
\$60000
\$40000
5th
10000
\$20000
•How about the MC of installing
ONE MORE screen?
•Cost of constructing ONE
screen = \$1,000,000
Installing the Interest income
•If you save the money in a
n-th screen
forgone (MC)
bank instead of investing it in
the cinema, how much do you
1
\$70000
get? (r=7% per annum)
2
\$70000
3
\$70000
4
\$70000
•So MC of installing ONE
MORE screen = \$1m∙0.07
5
\$70000
Installing the ↑ in revenue
(MB)
1st
\$100000
Interest income
forgone (MC)
\$70000
2nd
\$80000
\$70000
3rd
\$60000
\$70000
4th
\$40000
\$70000
5th
\$20000
\$70000
Should you install the first screen?
 YES! Because MB>MC
How about the second one? The third one?
How many screens would you install in total?
Q2)Mike gives a non-refundable \$100 to ACE
adventure to reserve a raft for a group rafting
trip in the New River. The raft has room for 5
people. He can only sell 3 tickets at \$25 each
for a total of \$75. Should Mike cancel the trip?
A)
B)
C)
D)
E)
Yes, because he will lost \$100.
No, because he is making \$75.
Yes if Mike values going on the trip at less than \$25.
No, because losing \$25 is better than losing \$100.
Yes, because he will lost \$25 on the venture.
Ans: D
• This is a question about opportunity cost.
• If Mike cancels the trip, he loses \$100 and
gets nothing. Hence, the net loss is \$100.
• If the trip goes as planned, Mike loses
\$100, and gets \$75 back. The net loss is
\$25.
• In other words, if he cancels, he loses
\$100; if he goes, he loses \$25 only.
• As a rational economic agent, what would Mike
choose?
• NOT to cancel the trip!
• Because losing \$25 is better than losing \$100
(D).
• The key word in the question is ‘non-refundable’.
That means the \$100 is already sunk. Mike
would endeavour to recover as much money as
possible from the venture.
Q3) How many hours should IBM employ
Pam to maximise its benefit from her
employment?
A)
B)
C)
D)
E)
1 hour.
2 hours.
3 hours.
4 hours.
5 hours.
Ans:D
• This is a slightly tricky question. However, all we have to
do is to apply the usual π-max principle: MR=MC.
• To summarise the information provided:
– Cost of all hardware needed to assemble a computer
is \$600
No. of Hours
1
No. of Computers
1
2
3
4
4
8
10
5
11
• To apply the MR=MC principle, first, we need to
find out that Marginal Increment in No. of
Computers in each hour.
No. of
Hours
No. of
Computers
from the n-th hour
1
2
3
4
1
4
8
10
1
3
4
2
5
11
1
• Then, we can find out the extra Revenue brought along
by the computers in each hour. (MR of hour)
• To calculate the MRhour, multiply the price (\$620) by
No. of
No. of
Hours Computers
from the n-th hour
MRhour (\$)
1
2
3
4
1
4
8
10
1
3
4
2
620
1860
2480
1240
5
11
1
620
• We then compute the MC of each working hour.
(MChour)
• MChour is the sum of Pam’s wage and all
hardware costs (\$600 each computer).
No. of No. of
Hours Computers from the n-th hour
MChour (\$)
1
1
1
640
2
4
3
1840
3
8
4
2440
4
10
2
1240
5
11
1
640
• To find the No. of hours that maximises IBM’s
profit, find where MRhour = MChour.
• So the answer is 4 hours (D).
No. of
Hours
MChour (\$)
MRhour (\$)
1
2
3
4
640
1840
2440
1240
620
1860
2480
1240
5
640
620
• Just to show that profit has been maximised...
• At 4th hour, Marginal Profit = 0 (feature of π-max)
No. of Hours MChour (\$)
1
640
2
1840
3
2440
4
1240
5
640
MRhour (\$)
620
1860
2480
1240
620
Mπhour (\$)
-20
20
40
0
-20
Q4) How many hours should IBM employ
Pam to maximise its benefit from her
employment if output price is 640?
A)
B)
C)
D)
E)
1 hour.
2 hours.
3 hours.
4 hours.
5 hours.
Ans:E
• We use the same technique as in Q3.
• However, the selling price of computers has
changed to \$640.
• This may affect Pam’s number of working hours.
• Is MC affected by the price change? How about
MR?
• MC – no change. MR – different now.
(recalculate)
• To calculate the new MRhour schedule, multiply
\$640 by ∆Computers for each hour.
No. of No. of
Hours Computers from the n-th hour
MRhour (\$)
1
1
1
640
2
4
3
1920
3
8
4
2560
4
10
2
1280
5
11
1
640
• To find the No. of hours that maximises IBM’s
profit, find where MRhour = MChour.
• So the answer is 5 hours (E).
No. of
Hours
MChour (\$)
MRhour (\$)
1
2
3
4
640
1840
2440
1240
640
1920
2560
1280
5
640
640
Note: When there is an increase in output price, the suppliers are
likely to increase their output, and hence employment.
• Just to show that profit has been maximised...
• At 5th hour, Marginal Profit = 0 (feature of π-max)
No. of
Hours
MChour (\$)
MRhour (\$)
Mπhour (\$)
1
640
640
0
2
1840
1920
80
3
2440
2560
120
4
1240
1280
40
5
640
640
0
Q5)Chris has been charging \$1 for a pound of
potatoes. Suppose Chris faces a linear
demand curve. When P↓ to \$0.90, TR drops.
When P↑ to \$1.10, TR also drops. Why?
A) \$1 is the equilibrium price for potatoes.
B) AT \$0.90, there is excess demand for potatoes.
C) \$1.10 is more than Chris’s customers’ reservation
prices.
D) Price elasticity of demand is unitary at \$1.00.
E) Both A and D must be true.
Ans: D
• (A) claims that \$1 is the equilibrium price.
• There is no basis for that.
• To determine the equilibrium price, we need to
have BOTH the demand and supply schedules.
Without this information, we cannot tell what
equilibrium price is.
• Therefore, both (A) and (E) are wrong.
• Note that (B) and (C) also require additional
supply and demand information. Therefore, they
cannot be correct.
• ε must be unitary at \$1 according to what
happened.
• When demand is price inelastic, reducing
the price would lead to a drop in TR. That
is because %↑Qd < %↓P.
• When demand is price elastic, raising the
price would mean losing many customers,
since they are all very sensitive to price
changes (%↓Qd > %↑P)
• Since TR decreases whenever there is a
deviation from P = \$1.00, \$1.00 must be the
separation point between the price elastic part of
the demand curve, and the price inelastic part of
the demand curve.
• Therefore, (D) is the correct answer.
Elastic
Unitarily Elastic
\$1
Inelastic
Q
Total revenue
P
0
0.9
1
Price
1.1
Q6) Pat earns \$25,000 per year. Her partner, Chris,
earns \$35,000 per year. They have 2 children.
Childcare for their children is \$12,000 per year.
Pat has decided to be a stay-home mum. Pat
must…
A)
B)
C)
D)
E)
Be irrational.
Value spending time with the children by more than \$25,000.
Value spending time with the children by more than \$12,000.
Value spending time with the children by more than \$13,000.
Value spending time with the children more than Chris does.
Ans: D
Pat has to choose between two alternatives.
• Net gain from alternative “go work and pay for childcare”
= 25000-12000 + 0 (value of quality time with her
children)
= \$13000
• Net gain from alternative “Take care of children herself”
= 0 – 0 + value of quality time with her children
= value of quality time with her children
• Pat chose Choice II (stay-home mum), it must be the
case that
– value of quality time with her children >= \$13000
Q7)Suppose at the market eq. price of natural gas,
price elasticity of demand is -1.2, and price
elasticity of supply is 0.6. What will result from
a price ceiling that is 10% below the mkt eq.
price?
A)
B)
C)
D)
A shortage equal to 1.8% of the market eq. quantity.
A shortage equal to 0.6% of the market eq. quantity.
A shortage equal to 18% of the market eq. quantity.
A shortage equal to 6% of the market eq. quantity.
Ans: C
Price Ceiling – diagrammatic approach
Price
Demand
Supply
Note that the price ceiling has
impact on quantity demanded
AND quantity supplied.
Pe
Price Ceiling
Pc
Shortage
Qs
Qe
Qd
Quantity
Finding The New Qs
%Qs
 S
%P
P
S
%Qs   S  %P
 0.6  ( 0.1)
PC
 0.06
Qs  0.94Qe
QS
Qe
Q
Finding The New Qd
%Qd
 D
%P
P
D
%Qd   D  %P
 1.2  ( 0.1)
PC
 0.12
Qd  1.12Qe
Qe
Qd
Q
Calculating the Shortage
• To calculate the shortage, simply find the
difference between Quantity Demanded and
Quantity Supplied.
• Both Qd and Qs have been expressed in terms
of Qe.
• Qd-Qs = 0.18Qe
• Therefore, the shortage is 18% of the original eq.
quantity. Hence, (C).
Q8)Suppose the demand for gourmet coffee can
be represented by a linear demand curve. At
the prevailing market price, the INCOME
ELASTICITY of demand for gourmet coffee is
2. When income rises, the demand for
gourmet coffee:
A)
B)
Becomes less elastic at every price.
Becomes less elastic at the price that prevailed before
the change in income.
C) Becomes more elastic at every price.
D) Becomes more elastic at price that prevailed before
the change in income.
E) Both A and B are both correct.
Ans: C
• The first elasticity mentioned in the question is INCOME
ELASTICITY.
• Income elasticity measures the responsiveness of
quantity demanded to changes in income.
• A positive figure means the product is a normal good. A
negative figure denotes inferior good.
• The second elasticity, the elasticity mentioned in the 5
options, refers to price elasticity of demand for gourmet
coffee.
• What affects the price elasticity of demand?
• Many factors, among which, the proportion of
expenditure on the item. (↑%→↑ε)
• The INCOME ELASTICITY is 2.
• Suppose income now rises by 10% and price
does not change.
• Quantity demanded will rise by 20%.
• Consumers are now spending a HIGHER
PROPORTION of their income on gourmet
coffee.
• Therefore, the PRICE ELASTICITY of demand
should now be MORE ELASTIC at all prices
than in the past (before income increases).
• Hence C.
Q9)Other things being equal, the increase in rents
that occur AFTER abolishing rent control is
smaller when…
A)
B)
C)
D)
E)
The own price elasticity of demand is inelastic.
The own price elasticity of demand is elastic.
The own price elasticity of demand is unitarily elastic.
Rented homes and owned homes are substitutes.
Rented homes and owned homes are complements.
Ans: B
• Rent control is a form of PRICE CEILING.
• Price Ceiling is set at a price LOWER than
the market equilibrium price.
P
D
S
Pe
Price Ceiling
Q
• When Rent Control is imposed, Qd > Qs.
• Equilibrium is not reached.
• And when the Price Ceiling is lifted, the
market equilibrium quantity and price
should be restored eventually.
• Price (rent) should increase.
• Because supply is upward sloping,
↑P → ↑ TR
Relative inelastic
P
D
S
Pe
Price Ceiling
Relative elastic
Q
Hence, the increase in rents that occur AFTER
abolishing rent control is smaller when
(B) The own price elasticity of demand is elastic.
Q10) What might cause a supply function to shift
to the LEFT?
An increase in the product’s own price.
An expectation that the product’s own price will fall in
the future.
C) Endorsement of the product by a popular celebrity.
D) An expectation that the product’s own price will rise in
the future.
E) A decrease in the price of one of the inputs to making
the product.
A)
B)
Ans: D
• When Supply shifts to the LEFT, is Supply increasing or
decreasing?
– Decreasing.
• When Supply shifts to the left, quantity supplied at all
prices drops.
• The shifting of the Supply schedule can be caused by
anything but a change in the current own price.
• A change in the current own price of the product leads to
a change in Qs only. Hence (A) is wrong.
• (C) is also obviously wrong.
• When a product is publicly embraced by
celebrities, DEMAND is affected (demand
will shift to the right).
• The celebrity factor does not affect the
Supply side.
• Hence, (C) can be eliminated.
• (E) is a sound reason for changes in
Supply.
• A drop in the cost of production, esp.
variable costs, can shift the Supply curve.
• However, the Supply should shift to the
right instead of shifting to the left.
• Therefore, (E) is not the correct answer.
• That leaves us with options (B) and (D).
• Both are related to expectations of the
future price.
• Expectations on the future price can shift
the supply curve.
• Note: not talking about current price.
• If a supplier expects price will be higher in
the future…
• Current stock should be held back as any
unit sold in the future earns more revenue
than that at present.
• As a result, (D) is the correct answer.
```